VC Delusions

VCs like to fancy themselves as numerate folks--but oddly enough they seem to have a skewed sense of probability.

That's what a new report on funding trends from John Paglia, an associate professor of finance at Pepperdine University, indicates. The results of his survey raise troubling questions about just how realistic Silicon Valley's moneymen are about their ability to make profits in the current, depressed economy--and may help explain why so many mediocre venture firms are still hanging around.

Paglia found that VCs expected their median investment returns to be about 42%, based on their expectations for how fast their portfolio companies would grow and how long VCs expected to fund them before a sale or an IPO.

The implied rate of return on these investors' last actual funds? Just 27%, using the same analysis.

The gap "is kind of a strange finding," Paglia told Forbes. Especially considering other funders of private companies were much more realistic about their returns: Banks expected median returns of just 6.5% on their investments and received 7%, and private-equity firms actually did better than expectations. They anticipated 25% returns, and instead had actual, implied returns of about 32%.

The implied returns, Paglia notes, are not actual returns from VC funds; those profits have been far lower in recent years, according to research outfits like Cambridge Associates.

Paglia gathered his data from 185 venture firms in March and April of this year, after the economic slowdown had already taken hold.

So what gives? VC firms' expectations about time horizons for M&A and IPO deals were realistic, Paglia's data shows. These guys know that it's taking longer to sell a company or take it public these days, which hurts their returns.

What they don't seem to understand is how the recession is curbing sales at venture-backed start-ups. For nascent and more mature start-ups, VCs' expectations about sales multiples were far greater than the actual multiples achieved by companies in their last funds, according to the report, which was discussed at an event Thursday in San Jose. The study is part of a new "Private Capital Markets Project" at Pepperdine's Graziadio School of Business and Management.

It's also possible that VCs, many of whom fancy themselves captains of the Silicon Valley universe, may have an inflated sense of their own intuition and business smarts. Paglia says he was surprised that 67% of venture capitalists surveyed named "gut feel" as one of their investment-analysis techniques; this compared with 43% who acknowledged relying on discounted cash-flow models.

VCs' boundless optimism and belief in the power of new ideas has helped fuel many a successful start-up. But right now, some of them appear to have their head in the sand.